La Française: High yields in the present market environment

17 juni 2022

By Gabriel Crabos, High Yield Portfolio Manager, La Française AM

Given the current inflationary environment, we tend to favor High Yield issuers involved in Defensive sectors such as Telecom, Healthcare and Gaming, over more consumer-oriented sectors such as Retail, which are more exposed to recession risk.

We also believe that commodity producers in Oil & Gas and Mining sectors, which would benefit from extremely strong free cash flow generation, should be favored over commodity consumers, like issuers in the Chemicals sector, where pricing power is not as strong. Lastly, we are cautious on heavily indebted sectors such as Real Estate, as higher interest rates affect asset valuations and borrowing costs.

Rising inflation and High Yield returns

At a fundamental level, rising inflation leads to lower profitability as inputs costs (raw materials, energy, wages…) affect operating margins, cash-flow generation and indebtedness. As a result, credit ratios, such as net leverage or interest coverage, will deteriorate leading to increased credit risk and wider credit spreads. However, we need to make the distinction between (i) price makers, which have the ability to pass inflation through to customers thereby protecting their margins, and (ii) price takers which do not. We expect the credit spreads of price makers to remain relatively sound, compared to price takers.

On a more technical note, rising inflation leads to higher interest rates, which in turn has a negative impact on the performance of the High Yield asset class. As an example, at end of May 2022, the modified duration of the BofA Global High Yield index stood at 4.4x, which means that if rates increase by +100 bps, the performance will be negative by -4.4% (excluding any positive effect from carry, and any positive or negative effects from the evolution of spreads).

High Yield market in the second half of the year

While we believe that a large portion of the increase in interest rates by Central Banks is now priced by the market, especially in the United States, we remain cautious on Global High Yield spreads for the second half the year, as we expect market volatility to remain heavy. From a geographical perspective, we favor US High Yield issuers over European High Yield issuers as we believe US issuers are far more insulated from the Russia/Ukraine war effects, rating trends are in much better shape in the United States with upgrade/downgrade ratios above 1x, refinancing activities will impact the cost of debt of European issuers more than US issuers, and European issuers will be more affected by increasing pressure on peripherical rates with the BTP-Bund spread at its highest level (more than 200bps) over the past 2 years.

Following strong 1Q22 results, we believe corporate fundamentals will start to be affected in 2Q22 due to rising inflation and slower economic growth. However, we expect that most High Yield corporates, especially in the BB rating segment compared to the CCC segment, will be able to absorb these negative shocks as credit ratios and liquidity levels remain at strong levels compared to the past few years. We also note that refinancing risk is rather limited as approximately 10% of High Yield bonds are due by 2024 in the United States compared to 20% in Europe. Consequently, we believe that High Yield default rates will moderately increase in the second half of the year but will not overshoot.